The industry saw strong growth in 2007 despite the start of the subprime crisis and was still expanding fast until the summer last year, when the credit crunch began to take its toll.

“This year the syariah banks are going to be exposed to the crisis the entire year. Those who survive this year will come out as winners, but others, especially the smaller banks, could merge, be taken over, or simply disappear,” BMB Islamic UK Ltd chief executive officer Dr Humayon Dar said in a media interview in Kuala Lumpur yesterday.

Islamic finance is distinctively different from conventional banking in principles. But it does not operate in isolation from the mainstream financial market and hence is not spared from the credit crunch, Humayon said.

Consolidation is a positive development for the industry since it will help pool the Islamic assets under fewer but stronger institutions, he said.

The Western banks are now more convinced about Islamic banking potential after they saw the sector’s resilience in the face of the subprime crisis.

On the other hand, some big financial institutions from the UK and the US, which entered the market four to five years ago in chase of the huge oil wealth, were disappointed by Islamic finance, he said, because they failed to secure business from syariah investors.

“It is very difficult for non-Islamic institutions to sell syariah banking products. The syariah investors are not going to trust someone who has conventional products in his left hand, Islamic products in his right hand and who sits in the bar drinking,” Humayon observed.

London-based BMB Islamic provides syariah structuring and advisory services to mainly financial institutions. It is part of the Cayman Islands-registered asset management firm BMB Group Ltd, whose parent is in Brunei.

BMB Islamic was recently named the Best Syariah Advisory Firm in Islamic Finance News Poll conducted by Kuala Lumpur-based Redmoney Group, and Humayon was in Kuala Lumpur to attend the award ceremony.

Syariah finance is a blend of Islamic economics and modern lending principles and its products can be sold to Muslims and non-Muslims.

While it was previously a small market catering to Muslims who wanted to avoid interest-based conventional banking, Islamic finance has become popular in recent years due to cash-rich Gulf Muslim investors and rising demand for ethical investing.

Non-Muslim investors have also been looking for less risky alternatives since the onset of the global credit crisis over a year ago cast doubt on many Western risk management practices.

But the Islamic finance sector is still relatively small and the industry wants to grow its market share to become a global alternative to conventional banking.

Many banks including OCBC have set up Islamic banking businesses to tap opportunities in the US$1 trillion industry. OCBC’s Malaysian unit launched its Islamic banking subsidiary, OCBC Al-Amin, last month.

“Islamic banking is getting a firmer foothold in the market right now and it has attracted not just Muslims but also non-Muslims not just in Malaysia but in the other parts of the world as well,” OCBC Al-Amin Bank chief executive Syed Abdull Aziz Syed Kechik told reporters.

“(In) Islamic banking, there is a lot of other governance to be put in place to enhance the confidence and enhance the risk management through the syariah governance and framework.”

He said non-Muslims now make up half of the bank’s Islamic banking customers.

Islamic banking products such as home loans and insurance have drawn interest from Malaysia’s ethnic Chinese and Indian minorities.

Under Islamic insurance, or takaful, members contribute to a pool of funds which is used to indemnify participants who suffer a loss. Profits made from investing om the funds are distributed among members.

Globally, syariah bonds are among the fastest growing Islamic finance instruments, with recent issuers coming from non-traditional Muslim markets such as Japan.

There are more than 300 Islamic financial institutions worldwide and the sector is valued at about $1 trillion, just a fraction of the the conventional global banking industry.

OCBC Al-Amin will roll out more products to bolster its customer base, including four trade financing murabaha instruments this month, Syed Abdull said.

In a murabaha deal, a financier such as a bank buys a commodity and sells it to the customer at a higher price, complying with Islam’s ban on interest.

“We’re looking at teens percentage in terms of growth for 2008,” Chew said. “Next year probably (there) will still be growth, possibly moderate a bit because the demand may have come down a bit from purchasing of capital items, large ticket items like houses and cars.” – Reuters

Strict rules on transparency and simpler deal structures saved syariah lenders from the worst of the current credit crisis, but their ability to survive future shocks is in question because they have few instruments to guard against wild swings in currency and interest rate movements.

“To the extent there are not enough syariah-compliant liquidity and risk management products, then clearly Islamic finance would be disadvantaged compared to conventional banks and would be less able to manage their liquidity risks,” said Hussein Hassan, head of Islamic structuring at Deutsche Bank.

The US$1 trillion (RM3.59 trillion) industry bans banking structures that are vague or ambiguous to avoid exploitation – a rule which some argue shuts out the use of common hedging instruments such as currency and interest rate swaps and futures contracts.

But as more markets embrace Islamic finance and the need for risk protection increases, there are growing attempts to find syariah hedging tools.

More complex derivatives have come under widespread scrutiny by regulators and governments in the West for their role in the credit crisis. Some products have been blamed for spreading risks of bad assets rather than containing them and amplifying the impact of losses in the financial slump.

Derivatives were a prickly issue in Islam even before the US subprime mortage market collapsed. Reflective of the diverse interpretations of Islamic law, the industry is divided over the use of derivatives – and for different reasons.

This has left Islamic institutions with far fewer hedging devices than their conventional peers.

These suspicions have deepened with derivatives having evolved from relatively simple contracts such as foreign-exchange forwards to complex tools like credit default swaps, over-the counter-contracts between two parties that bet on whether a company will default on its bonds within a certain time.

The conventional credit derivatives market alone was estimated to be worth some US$55 trillion (RM197.45 trillion) by last October.

With derivatives seen as a key trigger for the financial crisis and ensuring global economic downturn, opinion in Islamic finance may have now swung in favour of the conservative view.

“Just as there are fewer takers for conventional derivatives, fewer Islamic investors are biting at Islamic derivatives,” said Hooman Sabeti, an Islamic finance lawyer with Allen & Overy.

“Similarly, new participants in Islamic derivatives with the fortitude to proceed are steering away from more controversial structures and embracing more conservative ones.”

Some syariah advisers, however, permit derivatives as long as they are used to hedge risks on existing investments and not for speculation.

The difficulties with this argument are clear.

“Islam encourages you to manage your risk,” said Agil Natt, chief executive of INCEIF, an Islamic university based in Kuala Lumpur. “But when does risk management end and gambling begin?”

Derivatives are also avoided as their underlying assets can be uncertain, as many loss-laden Western banks and investors have discovered.

“In Islamic law, there must be something tangible that you are selling,” said Mohammad Akram Laldin, a syariah scholar who sits on various syariah advisory boards including HSBC Amanah. “You cannot be selling something in which you do not know the status of the subject matter.”

Last year, CIMB Islamic, the world’s top arranger of Islamic debt, launched a forex hedging tool where investors enter into an Islamic transaction with the bank.

The net proceeds – which are similar to the premium paid for conventional options – gives investors the right to exercise the option at the agreed rate on the maturity date.

But some bankers say the industry is struggling to find enough Islamic contracts that can be used to create derivatives.

“Most of the contracts that we have today aren’t entirely and immediately transferrable towards structuring derivatives products,” said Deutsche’s Hussein.

“Apart from ‘arbun’, which is the contract that is used mostly to do options, it’s not immediately clear that we’ve got enough other contracts that can be used to do other things.” Under an arbun contract, a purchaser makes a deposit (which forms part of the purchase price) to buy particular assets at a later date. Should the sale not proceed, the seller keeps the deposit.

Another difficulty is that Islamic finance contracts are subject to varying interpretations due to different readings of the syariah.

The International Swaps and Derivatives Association is working on a template to standardise the main terms for over-the-counter syariah derivative contracts.

“In the Islamic market acceptance has to come from a wide range of independent syariah boards, which might be challenging,” said Mahmoud Abushamma, HSBC’s head of syariah division in Jakarta. – Reuters

A young man makes his career choice and decides to become a successful banker, just like his father.

Rudi Prenzlin

Monday, February 23, 2009

A young man makes his career choice and decides to become a successful banker, just like his father.He wants to prepare for the role and asks his father: “What must I do to become a successful banker, just like you?”

“Son,” says the father, “you must follow these three simple rules: first, don’t lend money to those who don’t have any; second, don’t lend money to those who need it badly; and third, the most important, don’t lend your own money.”

Sound advice in these troubled times. It is a shame that many of today’s bankers either never received this sound advice, or ignored it!

In last week’s article, “Credit crunch opens doors for other possibilities” I argued that Islamic banking institutions were weathering the present financial crisis comparatively well as they are insulated from the disasters in the interbank market and the mess in the derivatives markets.

A number of readers raised the logical question of how Islamic banks manage to stay in business without charging interest.

To recap, one of the basic principles of Islamic banking is the prohibition of riba (usury or interest).

Other principles are based on simple morality and common sense, which are by no means unique to Islam. For example, usury was also prohibited by the Old as well as the New Testament.

The Islamic economic system is concerned with social justice to ensure that none of the parties is being exploited without inhibiting individual enterprise.

Extended to the Islamic financial system, this means that the funds individuals and/or companies put at risk share the profits or losses resulting from the enterprise. This concept of sharing the delights or pain of the outcome of business is a progressive one. Islamic banking encourages better resources management, in particular as outright speculation is not permitted by Shariah ie Islamic law.

The participants are keeping pace with sophisticated techniques and have developed products that not only are ethically motivated but also profitable.

At their core, most Islamic financial products are essentially the same as their conventional equivalents. The main difference is the absence of interest and often complicated procedures to ensure compliance with Shariah.

For example, in Islamic housing finance the risks involved are shared between the bank and the borrower, rather than transferring all the risk to the latter.

The most commonly contract used is the diminishing mazurka (partnership) contract.

In this case the bank and the borrower form a partnership, with the bank providing up to 95 percent of the purchase price, and the borrower 5 percent.

The borrower buys out the ownership share of the bank which makes its profit from the rent paid by the client for the share the bank owns. This happens over a period of, usually, 15 to 30 years.

Should the borrower default on a rental or principal repayment, the bank may advance the borrower an interest- free loan to enable him to continue the payments in anticipation that he will pay in full when he is able to.

The good news is that during this period of distress, the borrower retains his home rather than face eviction.

Having said this, Islamic banks still appraise credit risk, and indeed are more cautious about who they finance than conventional banks.

Rudi Prenzlin is the chief financial officer of the Hong Kong Islamic Index

The investment environment might not look too rosy for now but people are still generally receptive towards investment products that offer guaranteed capital protection, investment diversification and insurance protection.

This is evident from the simple survey conducted in August 2008 by CIMB Aviva Malaysia (CIMB Aviva) which showed 67.9% of respondents saying they will invest in a product that offers all the three elements.

Asian markets such as China, India, Philippines, Indonesia, Thailand and Malaysia are still the preferred investment location with 74% choosing Asia as the continent that they think they would be interested to invest in now vs 10.7% for Australia or 5.4% for North America.

“CIMB Aviva decided to get some feedback on investor sentiment that is currently very difficult to predict due to unsettling factors such as global economy slowdown, rising cost of living and local political developments. This survey gives us a better picture of what to expect and supported the strategy of our latest product, CIMB Islamic Market Select,” said Encik Zainudin Ishak, CEO of CIMB Aviva Takaful Berhad.

“CIMB Islamic Market Select is a Shariah-compliant product which provides a 100% capital protected guarantee along with the upside of investing in 17 different countries. This means not only portfolio diversification that mitigates overall portfolio risk but also a higher potential for growth. The fact that most of those surveyed still view Asia optimistically means this is an ideal product for all,” he added

CIMB Islamic Market Select gives investors the opportunity to ride on the existing investment wave of mature markets such as the US, promising Asian markets such as China and India plus the added advantage of investing into new emerging markets such as Brazil and Turkey which are set to take off as the next investment hotspots offering potential for long-term growth potential.

When applied to historical data, Market Select’s dynamic investment allocation strategy gives average annual returns of 16.5% and 23.6% for its three-year and five-year plan which means potentially higher returns than a conventional fixed deposit account.

A CIMB Islamic Market Select investor also benefits from takaful coverage, which pays surviving nominees a maximum of 125% of his single investment if he passes away before the investment matures.

Market Select applies the Best Performing Strategy that refers to the Dynamic investment allocation strategy. With this strategy, the returns at maturity are allocated based on a 60:20:20-allocation rate for the three market categories. This means investors enjoy 60% of the return based on the best performing category and 20% respectively for the remaining two categories. This product offers the option of a three-year and a five-year select terms with the latter having the added flexibility of providing yearly income distribution.

CIMB Islamic Market Select is available at all CIMB Islamic branches, which are co-located at CIMB Bank’s 366 branches nationwide until 19 September 2008. For further information, investors can call 1 300 880 900 or visit http://www.cimbbank.com.my.

10. If you could securely invest your excess money in your deposit account within 17 countries across Asia, Africa, Europe, North and South America whilst benefiting from 100% capital protection and with an element of additional life cover protection, would you do so?

Who is CIMB Aviva?CIMB Aviva is a joint venture company between CIMB Group and Aviva plc. CIMB Group is Malaysia’s second largest financial services provider and one of Southeast Asia’s leading universal banking groups, and Aviva is the world’s fifth largest insurance group* and the largest insurance services provider in UK.

Through the joint venture, CIMB Aviva offers a comprehensive range of life insurance and takaful products and services via the 366 branches of CIMB Bank and CIMB Islamic, two subsidiaries under CIMB Group.

CIMB Aviva also rides on the global expertise of Aviva, which services 45 million customers in 27 countries around the world. Aviva recorded total sales of £49.2 billion (RM337.5 billion) at 31 December 2007 and funds under management of £359 billion (RM2.28 trillion) at 30 June 2008.

Muslims to be offered Sharia-compliant pensions by Government

Muslims are to be offered Sharia-compliant pension funds by a new Government body.

The scheme to provide retirement funds for millions who do not already have a company pension is likely to include a special option that would not invest in companies deemed sinful under Islam.

Ministers are keen to get Muslims saving with the Personal Accounts Delivery Authority, as many who have low-paid jobs or who have moved to Britain in recent decades are unlikely to have put away much for their old age.

The decision to provide a Sharia-compliant pension fund is another sign of the growing influence of Islamic law in British public life and in particular the country’s finance industry.

The prospect of some aspects of Sharia law such as divorce proceedings and dispute resolution being enshrined in the English legal system – raised by the Archbishop of Canterbury and Lord Chief Justice this year – remains highly controversial because of fears that the system discriminates against women and that a two-tier approach would be divisive.

But more and more financial products are being tailored to cater for Britain’s population of 2million Muslims.

The religion’s holy book, the Qu’ran, forbids Muslims from making money from money, so they cannot use products that involve the charging of interest nor invest in traditional financial services firms.

Gambling, drinking and pornography are also seen as immoral under Islam, so Muslims cannot put their money into companies that promote these activities.

The Islamic finance market is estimated to be worth £500million already and is growing rapidly.

Families can already get Sharia-compliant baby bonds under the Government’s Child Trust Fund scheme while the UK is likely to become the first Western country to issue Islamic bonds in order to raise money from the Middle East.

This year has also seen the launch of Britain’s first Islamic insurance company and pre-paid MasterCard. There are a handful of wholly Islamic banks in the country and several more that offer alternatives to mortgages which do not involve the charging of interest.

When the Personal Accounts Delivery Authority launches in 2012, as many as 10 million people who do not have a decent occupational pension will become automatically enrolled and made to save a minimum of 4 per cent of their earnings a year, matched by a 3 per cent contribution from their employer and 1 per cent tax relief from the Government.

Savers will be able to choose from a range of funds into which their money will be invested, with one option likely to be Sharia-compliant.

A spokesman for the authority said: “In early 2009 we will be consulting on the potential approach to investment. Issues that we envisage incorporating into the consultation document include the overarching investment objective, the default strategy and lifestyling of funds and fund choices beyond the default strategy.

“This will include the appropriateness of making available religion compliant funds (e.g. Sharia) and funds focussing on social, environmental and ethical issues.”

Its plan was backed this week by a report by the Pensions Policy Institute and the Equality and Human Rights Commission on how to improve the lot of Britain’s “under-pensioned”, such as disabled people, women and ethnic minorities, who in many cases have not worked long enough to be entitled to a full state pension of £90.70 a week when they retire.

The study said: “The inclusion of a Sharia-compliant investment choice might be important to encourage participation among some ethnic minority groups.”

Douglas Murray, director of the Centre for Social Cohesion think tank, said the Government should not be creating parallel financial or legal systems for different groups in Britain.

He said: “It’s a great mistake for the Government to think this is desirable or even necessary.”

Delegates at the Future Proofing Your Bank MEFX conference in Dubai on Sunday discussed the vexing issue of product development from an Islamic finance perspective. Standardisation was given the most attention, as it always seems to at conferences where Islamic finance is discussed, but how much progress is taking place with regards to the subject is still not certain.

Sanjay Vig, managing director of Alpen Capital, which was behind several high profile Sukuk, such as the Berber Cement Sukuk in Sudan and the Mobily telecoms issuance in Saudi Arabia, pointed out that the issue of standardisation was not just an issue between regions, but also sometimes between countries. He said that while the Mobily Sukuk was accepted in Saudi Arabia, it was not in the UAE.

Vig also said that sorting out the critical issue of uniformity was vital if Islamic finance wanted to become globally acceptable. Uniformity and replication of products would speed up the process because the complex documentation that is part and parcel of the current trend in Islamic finance was slowing down its spread. Any bank that became involved had to run the product past its Shari’ah board, which also added to the time it took to bring it to market. Uniformity would greatly speed up that process, he said.

Ghazanfar Naqvi, director of Islamic products for Saadiq in the UAE added that very few law firms in the region understood Islamic finance and he said they needed “to gear up” to be able to meet demand. One thing that would help product development, said Naqvi, would be if more conventional bankers moved over to Islamic banking. “You cannot teach banking to everyone, but you can teach Islamic [law],” he said.

Delegates were told that not more than 20 to 30 per cent of Islamic banks portfolios from the GCC are invested outside the region and that more diversification of risk was required. This, they were told, would also help to increase the awareness and popularity of Islamic finance.

Vig said that more international listings of Sukuk on exchanges like New York, Hong Kong and London would increase its visibility and he said would assure investors that by listing there, that they were meeting internationally recognised standards.

There was also talk among delegates about the role of Takaful in markets such as the UAE and Qatar where a huge real estate boom was taking place. Many wondered why Takaful had such a small share of the market, compared to conventional insurance, when so much money was being invested in real estate. Others expressed wonderment at why Islamic real estate investment trusts were not more popular, given that India, Pakistan and Malaysia were actively considering them.

The term “Islamic Investment Fund” in this article means a joint pool wherein the investors contribute their surplus money for the purpose of its investment to earn halal profits in strict conformity with the precepts of Islamic Shariah. The subscribers of the Fund may receive a document certifying their subscription and entitling them to the pro-rated profits actually accrued to the Fund. These documents may be called “certificates” “units” “shares” or may be given any other name, but their validity in terms of Shariah, will always be subject to two basic conditions:

First, instead of a fixed return tied up with their face value, they must carry a pro-rated profit actually earned by the Fund. Therefore, neither the principal nor a rate of profit (tied up with the principal) can be guaranteed. The subscribers must enter into the fund with a clear understanding that the return on their subscription is tied up with the actual profit earned or loss suffered by the Fund. If the Fund earns huge profits, the return in their subscription will increase to that proportion; however, in case the Fund suffers loss, they will have to share it also, unless the loss is caused by the negligence or mismanagement, in which case the management, and not the Fund, will be liable to compensate it.

Second, the amounts so pooled together must be invested in a business acceptable to Shariah. It means that not only the channels of investment, but also the terms agreed with them must conform to the Islamic principles.

Keeping these basic requisites in view, the Islamic Investment Funds may accommodate a variety of modes of investment which are discussed briefly in the following paragraphs.

Equity Fund

In an equity fund the amounts are invested in the shares of joint stock companies. The profits are mainly achieved through the capital gains by purchasing the shares and selling them when their prices are increased. Profits are also achieved by the dividends distributed by the relevant companies.

It is obvious that if the main business of a company is not lawful in terms of Shariah, it is not allowed for an Islamic Fund to purchase, hold or sell its shares, because it will entail the direct involvement of the share holder in that prohibited business.

Similarly the contemporary Shariah experts are almost unanimous on the point that if all the transactions of a company are in full conformity with Shariah, which includes that the company neither borrows money on interest nor keeps its surplus in an interest bearing account, its shares can be purchased, held and sold without any hindrance from the Shariah side. But evidently, such companies are very rare in the contemporary stock markets. Almost all the companies quoted in the present stock market or in some way involved in an activity which violates the injunctions of Shariah.

Even if the main business of a company is halal, its borrowings are based on interest”. On the other hand, they keep their surplus money in an interest bearing account or purchase interest bearing bonds or securities.

The case of such companies has been a matter of debate between the Shariah experts in the present century. A group of the Shariah experts is of the view that it is not allowed for a Muslim to deal in the shares of such a company, even if its main business is halal. Their basic argument is that every share-holder of a company is a sharik (partner) of the company, and every sharik, according to the Islamic jurisprudence, is an agent for the other partners in the matters of the joint business. Therefore, the mere purchase of a share of a company embodies an authorization from the share-holder to the company to carry on its business in whatever manner the management deems fit. If it is known to the share-holder that the company is involved in an un-Islamic transaction, still, he holds the shares of that company, it means that he has authorized the management to proceed with that un-Islamic transaction. In this case, he will not only be responsible for giving his consent to an un-Islamic transaction, but that transaction will also be rightfully attributed to himself, because the management of the company is working under his tacit authorization.

Moreover, when a company is financed on the basis of interest, its funds employed in the business are impure. Similarly, when the company receives interest on its deposits an impure element is necessarily included in its income which will be distributed to the share-holders through dividends.

However, a large number of the present day scholars do not endorse this view. They argue that a joint stock company is basically different from a simple partnership period. In partnership, all the policy decisions are taken by the consensus of all the partners, and each one of them has a veto power with regard to the policy of business. Therefore, all the actions of a partnership are rightfully attributed to each partner. Conversely, the policy decisions in a joint stock company are taken by the majority. Being composed of a large number of share-holders, a company cannot give a veto power to each share-holder. The opinions of individual share-holders can be overruled by a majority decision. Therefore, each and every action taken by the company cannot be attributed to every share-holder in his individual capacity. If a share-holder raises an objection against a particular transaction in an annual general meeting, but his objection is overruled by the majority, it will not be fair to conclude that he has given his consent to the transaction in his individual capacity, specially when he intends to withdraw from the income attributable to that transaction.

Therefore, if a company is engaged in a halal business, however, it keeps its surplus money in an interest-bearing account, wherefrom a small incidental income of interest is received, it does not render all the business of the company unlawful. Now, if a person acquires the shares of such a company with clear intention that he will oppose the incidental transaction also, and will not use that proportion of the dividend for his own benefit, how can it be said that he has approved the transaction of interest and how can that transaction be attributed to him?

The other aspect of the dealings of such a company that it sometimes borrows money from financial institutions. These borrowings are mostly based on interest. Here again the same principal is relevant. If a share-holder is not personally agreeable to such borrowings, but has been overruled by the majority, these borrowing transactions cannot be attributed to him.

Moreover, according to the principals of Islamic jurisprudence borrowing on interest is a grave sinful act for which the borrower is responsible in the Hereafter; however, this sinful act does not render the whole business of the borrower as haram impermissible. The borrowed amount being recognized as owned by the borrower, anything purchased in exchange of that money is not unlawful. Therefore, the responsibility of committing a sinful act of borrowing on interest rests with the person who willfully indulged in a transaction of interest, but this fact does not render the whole business of a company as un-lawful.

Conditions for Investment in Shares

In the light of the forgoing discussion, dealing in equity shares can be acceptable in Shariah subject to the following conditions:

1. The main business of the company is not in violation of Shariah. Therefore, it is not permissible to acquire the shares of the companies providing financial services on interest, like conventional banks, insurance companies, or the companies involved in some other business not approved by the Shariah, such as the companies manufacturing, selling or offering liquors, pork, haram meat, or involved in gambling, night club activities, pornography etc.

2. If the main business of the companies is halal, like automobiles, textile, etc. but they deposit there surplus amounts in a interest-bearing account or borrow money on interest, the share holder must express his disapproval against such dealings, preferably by raising his voice against such activities in the annual general meeting of the company.

3. If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the dividend paid to the share-holder must be given charity, and must not be retained by him. For example, if 5% of the whole income of a company has come out of interest-bearing deposits, 5% of the dividend must be given in charity.

4. The shares of a company are negotiable only if the company owns some non-liquid assets. If all the assets of a company are in liquid form, i.e. in the form of money that cannot be purchased or sold, except on par value, because in this case the share represents money only and the money cannot be traded in except at par.

What should be the exact proportion of non-liquid assets of a company for the negotiability of its shares? The contemporary scholars have different views about this question. Some scholars are of the view that the ratio of non-liquid assets must be 51% at the least. They argue that if such assets are less than 50%, the most of the assets are in liquid form, therefore, all its assets should be treated as liquid on the basis of the juristic principle: The majority deserves to be treated as the whole of a thing. Some other scholars have opined that even if the non-liquid asset of a company or 33%, its shares can be treated as negotiable.

The third view is based on the Hanafi jurisprudence. The principle of the Hanafi school is that whenever an asset is a mixture of a liquid and non-liquid assets, it can be negotiable irrespective of the proportion of its liquid part. However, this principle is subject to two conditions:

First, the non-liquid part of the mixture must not be in a negligible quantity. It means that it should be in a considerable proportion. Second, the price of the mixture should be more than the price of the liquid amount contained therein. For example, if a share of 100 dollars represents 75 dollars, plus some fixed assets the price of the share must be more than 75 dollars. In this case, if the price of the share is fixed as 105, it will mean that 75 dollars are in exchange of 75 dollars owned by the share and the rest of 30 dollars are in exchange of the fixed asset. Conversely, if the price of that share fixed as 70 dollars, it will not be allowed, because the 75 dollars owned by the share are in this case against an amount which is less than 75. This kind of exchange falls within the definition of “riba” and is not allowed. Similarly, if the price of the share, in the above example, is fixed as 75 dollars, it will not be permissible, because if we presume that 75 dollars owned by the share, no part of the price can be attributed to the fixed assets owned by the share. Therefore, some part of the price (75 dollars) must be presumed to be in exchange of the fixed assets of the share. In this case, the remaining amount will not be adequate for the price of 75 dollars. For this reason the transaction will not be valid.

However, in practical terms, this is merely a theoretical possibility, because it is difficult to imagine a situation where a price of the share goes lower than its liquid assets.

Subject to these conditions, the purchase and sale of shares is permissible in Shariah. An Islamic Equity Fund can be established on this basis. The subscribers to the Fund will be treated in Shariah as partners “inter se.” All the subscription amounts will form a joint pool and will be invested in purchasing the shares of different companies. The profits can accrue either through dividends distributed by the relevant companies or through the appreciation in the prices of the shares. In the first case i.e. where the profits earned through dividends, a certain proportion of the dividend, which corresponds to the proportion of interest earned by the company, must be given in charity. The contemporary Islamic Funds have termed this process as “purification.”

The Shariah scholars have different views about whether the “purification” is necessary where the profits are made through capital gains (i.e. by purchasing the shares at a lower price and selling them at a higher price). Some scholars are of the view that even in the case of capital gains the process of “purification” is necessary, because the market price of the share may reflect an element of interest included in the assets of the company. The other view is that no purification is required if the share is sold, even if it results in a capital gain. The reason is that no specific amount of price can be allocated for the interest received by the company. It is obvious if all the above requirements of the halal shares are observed, the most of the assets of the company are halal, and a very small proportion of its assets may have been created by the income of interest. This small proportion is not only unknown, but also a negligible as compared to the bulk of the assets of the company. Therefore, the price of the share, in fact, is against the bulk of the assets, and not against such a small proportion. The whole price of the share therefore, may be taken as the price of the halal assets only.

Although this second view is not without force, yet the first view is more cautious and far from doubts. Particularly, it is more equitable in an open-ended equity fund because if the purification is not carried out on the appreciation and a person redeems his unit of the Fund at a time when no dividend is received by it, no amount of purification will be deducted from its price, even though the price of the unit may have increased due to the appreciation in the prices of the shares held by the fund. Conversely, when a person redeems his unit of the Fund at a time when no dividend is received by it, no amount of purification will be deducted from its price, even though the price of the unit may have increased due to the appreciation in the prices of the shares held by the fund. Conversely, when a person redeems his unit after some dividends have been received in the fund and the amount of purification has been deducted therefrom, reducing the net asset value per unit, he will get a lesser price compared to the first person.

On the contrary, if purification is carried out both on dividend and capital gains, all the unit-holders will be treated at par with the regard to the deduction of the amounts of purification. Therefore, it is not only free from doubts but also more equitable for all the unit-holders to carry out purification in the capital gains. This purification may be carried out on the basis of an average percentage of the interest earned by the companies included in the portfolio.

The management of the fund may be carried out in two alternative ways. The managers of the Fund may act as mudaribs for the subscriber. In this case a certain percentage of the annual profit accrued to the Fund may be determined as the reward of the management, meaning thereby that the management will get its share only if the fund has earned some profit. If there is no profit in the fund, the management will deserve nothing, but the share of the management will increase with the increase of profits.

The second option of the management is to act as an agent for the subscribers. In this case, the management may be given a pre agreed fee for its services. This fee may be fixed in lump sum or as a monthly or annual remuneration. According to the contemporary Shariah scholars, the fee can also be based on a percentage of the net asset value of the fund. For example, it may be agreed that the management will get 2% or 3% of the net asset value of the fund at the end of every financial year.

However, it is necessary in Shariah to determine any of the aforesaid methods before the launch of the fund. The practical way for this would be to disclose in the prospectus of the fund on what basis the fees of the management will be paid. It is generally presumed that whoever subscribes to the fund agrees with the terms mentioned in the prospectus. Therefore, the manner of paying the management will be taken as agreed upon on all the subscribers.

Ijarah Fund

Another type of Islamic Fund may be an ijarah fund. Ijarah means leasing. In this fund the subscription amounts are used to purchase assets like real estate, motor vehicles, or other equipment for the purpose of leasing them out to their ultimate users. The ownership of these assets remains with the Fund and the rentals are charged from the users. These rentals are the source of income for the fund which is distributed pro rated to the subscribers. Each subscriber is given a certificate to evidence his subscription and to ensure his entitlement to the pro rated share in the income. These certificates may be preferably called “sukuk” — a term recognized in the traditional Islamic jurisprudence. Since these sukuk represent the pro rated ownership of their holders in the tangible assets of the fund, and not the liquid amounts or debts, they are fully negotiable and can be sold and purchased in the secondary market. Anyone who purchases these sukuk replaces the sellers in the pro rated ownership of the relevant assets and all the rights and obligations of the original subscriber are passed on to him. The price of these sukuk will be determined on the basis of market forces, and are normally based on their profitability.

However, it should be kept in mind that the contracts of leasing must conform to the principles of Shariah which substantially differ from the terms and conditions used in the agreements of the conventional financial leases. The points of reference are explained in detail in my book “Islamic Finance.” However, some basic principles are summarized here: 1. The leased assets must have some usufruct, and the rental must be charged only from that point of time when the usufruct is handed over to the lessee.

2. The leased assets must be of a nature that their halal (permissible) use is possible.

3. The lessor must undertake all the responsibilities consequent to the ownership of the assets.

4. The rental must be fixed and known to the parties right at the beginning of the contract. In this type of the fund the management should act as an agent of the subscribers and should be paid a fee for his services. The management fee may be a fixed amount or a proportion of the rentals received. Most of the Muslim jurists are of the view that such a fund cannot be created on the basis of mudarabah, because mudarabah, according to them, is restricted to the sale of commodities and does not extend to the business of services and leases. However, in the Hanbali school, mudarabah can be affected in services and leases also. This view has been preferred by a number of contemporary scholars.

Commodity Fund

Another possible type of Islamic Funds may be a commodity fund. In the fund of this type the subscription amounts are used in purchasing different commodities for the purpose of the resale. The profits generated by the sale are the income of the fund which is distributed pro rated among the subscribers. In order to make this fund acceptable to Shariah, it is necessary that all the rules governing the transactions and fully complied with. For example:

1. The commodity must be owned by the seller at the time of sale, therefore, short sales where a person sells a commodity before he owns it are not allowed in Shariah.

2. Forward sales are not allowed except in the case of salam and istisna’ (For their full details my book “Islamic Finance” may be consulted).

3. The commodities must be halal, therefore, it is not allowed to deal in wines, pork, or other prohibited materials.

4. The seller must have physical or constructive possession or the commodity he wants to sell. (Constructive possession includes any act by which the risk of the commodity is passed on to the purchaser).

5. The price of the commodity must be fixed and known to the parties. Any price which is uncertain or is tied up with an uncertain event renders the sale invalid.

In view of the above and similar other conditions, it may easily be understood that the transactions prevalent in the contemporary commodity markets, specially in the futures commodity markets do not comply with these conditions. Therefore, an Islamic Commodity Fund cannot enter into such transactions. However, if there are genuine commodity transactions observing all the requirements of Shariah, including the above conditions, a commodity fund may well be established. The units of such fund can also be traded in with the condition that the portfolio owns some commodities at all times.

Murabahah Fund

“Murabahah” is a specific kind of sale where the commodities are sold on a cost-plus basis. This kind of sale has been adopted by the contemporary Islamic banks and financial institutions as a mode of financing. They purchase the commodity for the benefit of their clients, then sell it to them on the basis of deferred payment at an agreed margin of profit added to the cost. If a fund is created to undertake this kind of sale, it should be a closed-end fund and its units can not be negotiable in a secondary market. The reason is that in the in the case Murabahah, as undertaken by the present financial institutions, the commodities are sold to the clients immediately after their purchase from the original supplier, while the price being on deferred payment basis becomes a debt payable by the client. Therefore, the portfolio of Murabahah does not own any tangible assets, rather it comprises of either cash or the receivable debts, and both these things are not negotiable, as explained earlier. If they are exchanged for money, it must be at par value.

Bai’-al-dain

Here comes the question whether or not Bai’-al-dain is allowed in Shariah. Dain means “debt” and Bai’ means sale. Bai’-al-dain, therefore, connotes the sale of debt. If a person has a debt receivable from a person and he wants to sell it at a discount, as normally happens in the bill of exchange, it is termed in Shariah as Bai’-al-dain. The traditional Muslim jurists (fuqaha’) are unanimous on the point that Bai’-al-dain is not allowed in Shariah. The overwhelming majority of the contemporary Muslim scholars are of the same view. However, some scholars of Malaysia have allowed this kind of sale. They normally refer to the ruling of Shaf’ite school wherein it is held that the sale of debt is allowed, but they do not pay attention to the facts that the Shaf’ite jurists have allowed it only in a case where a debt is sold on its par value.

In fact, the prohibition of Bai-al-dain is a logical consequence of the prohibition of “riba” or interest. A “debt” receivable in monetary terms corresponds to money, and every transaction where money is exchanged from the same denomination of money, the price must be at par value. Any increase or decrease from one side is tantamount to “riba” and can never be allowed in Shariah. Some scholars argue that the permissibility of Bai’-al dain is restricted to a case where the debt is created through a sale of a commodity. In this case, they say, the debt represents the sold commodity and its sale may be taken as a sale of the commodity. The arguments, however, is devoid of force. For, once the commodity is sold, its ownership is passed on to the purchaser and it is no longer commodity of the seller. What the seller owns is nothing other than money, therefore if he sells the debt, it is no more than a sale of money and it cannot be termed by any stretch of imagination as the sale of the commodity. That is why this view has not been accepted by the overwhelming majority of the contemporary scholars. The Islamic Fiqh Academy of Jeddah which is the largest representative body of the Shariah scholars and is represented by all the Muslim countries, including Malaysia, has approved the prohibition of Bai’-al-dain unanimously without a single decent.

Mixed Fund

Another type of Islamic Fund maybe of a nature where the subscription amounts are employed in different types of investments, like equities, leasing, commodities, etc. This may be called a Mixed Islamic Fund. In this case if the tangible assets of the Fund are more than 51% while the liquidity and debts are less than 50% the units of the fund may be negotiable. However, if the proportion of liquidity and debts exceeds 50%, its units cannot be traded in according to the majority of the contemporary scholars. In this case the Fund must be a closed-end Fund.

This article considers the subtle differences between the two key players within the Islamic finance industry – Shari’a-compliant banks and Shari’a-based banks – and how they could co-operate to achieve the real potential of this market.

On 9 July 2007, the Bank of London and The Middle East (BLME) was launched in London. BLME is the second wholly Shari’a-compliant investment bank authorised and regulated by the UK’s Financial Services Authority (FSA). This brings the number of fully Islamic banks in the UK to three, with the total number of financial institutions offering Islamic financial services in the UK at 24. Another three Islamic financial institutions are in the process of applying for a licence with the FSA, showing the strength of the UK as the largest Islamic finance hub outside Muslim geographies.

Although a young segment of the financial industry, Islamic finance has gone through an exceptional growth period. Over the past 10 years, the industry has grown at a rate of 15-20% per year. This level of growth is expected to continue in the coming years and by far exceeds the rate of growth in conventional finance. The increase in wealth resulting from the rise in oil prices and the subsequent requirements for investment in oil-producing countries is a large contributor to the expansion of the Islamic finance industry. Coupled with relatively high returns, this attracts banks and investors alike.

Islamic financial products are not only offered by fully Shari’a-compliant banks but also by conventional banks employing specific distribution channels, such as Islamic windows and Islamic branches. The issue that arises is whether Islamic financial products offered by a conventional bank are equally acceptable to Muslims as those offered by fully compliant Islamic financial institutions. There is, after all, a difference in the level of Shari’a compliance of conventional and Islamic banks.
Shari’a Supervision

Islamic financial institutions have an additional layer of corporate governance over and above the governance mechanisms in place for conventional financial institutions. In addition to a supervisory board, independent external auditors, adequate policies and procedures and other governance mechanisms, Islamic financial institutions also have to ensure compliance with the Shari’a principles, which are reviewed and monitored by the Shari’a Supervisory Board (SSB). The role of the SSB is to issue fatwa (opinions) setting out how the bank’s operations should be carried out in order to be consistent with Shari’a rules and principles (ex-ante compliance). In addition, because of its role within the corporate governance framework, the SSB is also responsible for the monitoring of the institution’s Shari’a compliance in applying the fatwa in practice (ex-post compliance).
Shari’a Compliance

In order for a financial product to be Shari’a compliant, it needs to satisfy, at a minimum, the criteria of Shari’a law regarding the avoidance of Riba, Maysir and Gharar. Once these are satisfied and the bank obtains Shari’a supervisory board approval, the product or structure can be marketed as Shari’a compliant. As far as conventional banks are concerned, this is where Shari’a compliance stops. It does not constrain the bank from employing non-Islamically raised funds to invest in Islamic structures.
Shari’a Based Banks

A fully Shari’a-compliant or Shari’a-based bank takes the compliance with Shari’a law a step further. Not only do individual products have to meet all requirements but also all operations within the bank are required to be compliant with Shari’a law. This extends to contracts with suppliers, rental contracts and labour contracts. The bank is completely set up to work in line with the ethical framework of Shari’a, which makes it more likely to be able to structure all products to meet the requirements. In addition, there is no co-mingling of conventional and Islamically raised funds, since all funds are raised in line with Shari’a requirements.
Impact on Investment Decisions

The decision any investor, depositor, Sukuk issuer or other client of a bank will have to make is related to the trade-off between the level of Shari’a compliance and the reputation and historic track record of the bank.

A large conventional bank with a proven track record will provide a relatively higher degree of certainty than a newly established Islamic bank. In addition, large conventional banks have the advantage of the backing of a big balance sheet and structuring capabilities that are well beyond the potential of Islamic banks, at least at the moment. This becomes immediately clear when comparing the total assets of the largest Islamic bank with total assets of large conventional banks. At the end of 2006, the largest Islamic bank (Al Rajhi) had total assets of US$28.1bn. The likes of HSBC, Barclays and Citi, on the other hand, each had a total asset base close to US$2 trillion at the end of December 2006.

As a result, it is much easier for conventional banks to underwrite large Sukuk issues and to structure sizeable project finance structures than it is for Islamic banks. Between June 2006 and June 2007, five of the 10 biggest Sukuk arrangers were conventional banks. Issuers choose conventional banks for their proven track record, their ability to raise large sums of money and, most importantly, their competitive pricing.

Conventional banks, however, provide Islamic finance as part of a broader range of financial products and although the individual offerings are Shari’a-compliant and the distribution channel is different from other financial products, a conventional bank is likely to co-mingle funds raised in an Islamic manner with conventionally raised funds. In addition, conventional banks can hedge positions using innovative financial products that are often not allowed in Islamic banks, given the speculative nature of the majority of hedging products.

A small, relatively young Islamic bank does not have a long track record and can hence be seen by investors and depositors as carrying a higher risk. Although some comfort can be found in the fact that the bank is regulated, conventional banks are regulated in the same way. As a result of the smaller balance sheet size, Islamic banks are not currently in a position to underwrite large Islamic finance transactions unless they are part of a syndication effort and, even then, some transactions are out of their scope due to large exposure regulations and size limitations.

On the other hand, a Shari’a-based bank operates completely within the remit of the ethical framework defined by Shari’a law, something that could be of significant interest for Muslims. A fully Islamic financial institution will not only be audited internally and externally, but will also be subject to an annual review by the Shari’a supervisory board as an independent third party to ensure ongoing Shari’a compliance for the whole of the business. An Islamic window or branch of a conventional bank does not necessarily go through this type of ex-post compliance audit, and in any case does not have to report the results in its annual report.
Compete or Co-operate?

There is a strong call in the market to form an Islamic ‘mega’ bank but given the size of the individual Islamic banks, this appears to be quite a way off.

Although the number of Islamic banks is growing exponentially, their balance sheet size on a consolidated basis is not even remotely close to the size of any of the large conventional banks on their own. Thus, the two types of players operate in different market segments, which actually make them very complementary. In the end, there is a place for both Shari’a-compliant and Shari’a-based banks. By working closely together, they can achieve high market penetration and work on reaching the full potential of the market.